UK Economy

Quantitative easing (QE – the purchase of government securities by the central bank, financed through increases in base money) in the UK is not working. I should have written “not yet”, for posterior coverage reasons, but I’m running out of patience with a policy that (a) has been ineffective for the half year of its existence and (b) can be easily modified to make it more effective. Credit easing (CE – the outright purchase of private securities by the central bank) in the UK really hasn’t been tried. Of the total Asset Purchase Facility limit of £175 bn, up to £50 bn could have been used to purchase private securities outright. Instead, out of the just under £154 billion purchased up to 24 September 2009 (see here), only £2 bn of private securities have been purchased by the Bank of England. The rest of the £175 bn Facility has been or will be devoted to purchases of UK Treasury securities. No doubt this gives the Chancellor of the Exchequer a warm feeling inside, but from every other perspective it looks like a poor use of Bank of England resources.

Since QE started in January 2009, the Bank of England’s balance sheet has continued to explode, as is clear from the Table below, which shows the Bank of England’s Balance Sheet at the end of July 2007 (just before the crisis) and at the end of August 2009. The total size of the balance sheet rose from £80.3 bn to £220.3 bn. The peak of the Bank of England’s balance sheet size so far was at the end of July 2009, when it stood at £245.3 bn, more than three times its July 2009 size. This is the largest proportional increase in the size of the balance sheet of any of the leading central banks.

With monetary policy, both conventional and unconventional, having reached the limits of its effectiveness in most of the advanced industrial countries, the only instrument left for boosting demand is fiscal policy. By this I mean, until further notice) a cut in taxes or an increase in public spending financed either by borrowing from the public (domestic or foreign) or by borrowing from the central bank, that is, by creating base money.

Like all debt, public debt is both a wonderful and a dangerous social invention. It permits individuals and groups of individuals, including nations, to smooth consumption over time – it permits saving to be de-coupled from investment. In what follows it will be important not to use the word ‘debt’ as equivalent to ‘financial instrument’ or ‘financial claim’. Equity and other profit-, loss- and risk-sharing instruments also permit the de-coupling of saving and investment and the smoothing of consumption over time and across generations. When I refer to debt, it is narrowly defined as a financial instrument imposing fixed, non-contingent payment obligations on the borrower. Borrowing in this narrow sense creates a legal obligation to repay the debt with interest at some future date.

On September 16 and 17, the Earth Institute at Columbia University (well, at least it’s not called the Universe Institute) and the Asian Development Bank organised a conference at Columbia University on The Future of the Global Reserve System. Papers were presented by the members of the Asian Development Bank’s International Monetary Advisory Group (IMAG), of which I am one (the other members are Prof. Jeffrey Sachs, Dr. Nirupam Bajpai, Dr. Maria Socorro G. Bautista, Prof. Barry Eichengreen, Dr. Masahiro Kawai, Prof. Felipe Larrain, Prof. Joseph Stiglitz, Prof. Charles Wyplosz, Dr. Yu Yongding).

The paper “Is there a case for a further co-ordinated global fiscal stimulus” is my take on the subject assigned to me for the New York conference: “Are the coordinated stimulus plans working and are they effective? Should we continue with fiscal stimulus? Are there other approaches to aggregate demand management?”

I will publish the paper in this blog in two or three installments, as I revise the initial draft. Installment one follows below.

Introduction

For further internationally co-ordinated expansionary fiscal policy measures to be desirable today, a number of conditions must be satisfied.

First, there must be idle resources – involuntary unemployment of labour and unwanted excess capacity. Output and employment must be demand-constrained.

Second, there must be no more effective way of stimulating demand, say through expansionary monetary policy.

Third, expansionary fiscal policy must not drive up interest rates, either by raising the risk-free real interest rate or by raising the sovereign default risk premium, to such an extent that the fiscal stimulus is emasculated through financial crowding out.

Fourth, at given interest rates, the expansionary fiscal policy measures are not neutralised by direct crowding out (the displacement of private spending by public spending or of public dissaving by private saving at given present and future interest rates, prices and activity levels). Such direct crowding out can occur in the case of tax cuts (strictly speaking, cuts in lump-sum taxes matched by future increases in lump-sum taxes of equal present discounted value) because of Ricardian equivalence/debt neutrality. In economies with very highly indebted households, debt neutrality can occur when taxes on households are cut, because of what I shall call “Minsky equivalence” (see Minsky (2008)). Increases in public spending on real goods and services (“exhaustive” public spending) can fail to boost aggregate demand because of a high degree of substitutability (in the utility functions or the production technology) between private consumption and investment on the one hand and public consumption and investment on the other.

Fifth, there must be cross-border externalities from expansionary fiscal policies that cause decentralised, uncoordinated national fiscal expansions to be suboptimal.

This paper will consider these issues in turn. After reaching some fairly discouraging conclusions on the scope for further conventional expansionary fiscal policy now, unless there are significant political realignments in fiscally challenged nations that support coalitions in favour of significant future fiscal tightening through tax increases or public spending cuts, I briefly outline some unconventional fiscal/financial policies that may be effective in their own right and may help to enhance the effectiveness of conventional expansionary fiscal policy. Collectively, they can be characterised as the equitization of debt – household mortgage debt, bank debt and public debt.

Lord Turner, chairman of the UK’s Financial Services Authority, has set the cat among the financial pigeons by making highly critical comments about the City of London and financial intermediation in general. He recommended some drastic remedies, and suggested considering a global tax on financial transactions – a generalised Tobin tax. James Tobin proposed a tax on foreign exchange transactions to stabilise floating exchange rates and achieve greater national monetary policy autonomy in a world of increasing financial integration.

The Tobin tax was never implemented, which is just as well from the perspective of its declared objectives: it could have increased exchange rate instability and was unlikely materially to enhance national monetary policy autonomy. From a political perspective, it may be more surprising that it was never implemented. Even at a very low rate, the Tobin tax could have been a massive government revenue raiser. Distortionary taxes that raise large revenues, including transaction taxes on financial and real assets – such as the UK’s stamp duty on property – are, after all, a common feature of the political landscape.

What problem would a Tobin tax on financial transactions solve? Lord Turner asserts, in an interview with Prospect magazine, that the UK financial sector has grown too big; that some financial sector activity is worthless from a social perspective; that the sector is destabilising the British economy; and that new taxes may be required to curb excessive profits and pay in the sector. “If you want to stop excessive pay in a swollen financial sector you have to reduce the size of that sector or apply special taxes to its pre-remuneration profit,” he says. Even if all these assertions are correct, they do not imply the need for a Tobin tax.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.